A collection of often sceptical, always candid observations and insights on the US economy and large-cap equity markets. Readers have observed my style and perspective to be that "the emperor has no clothes," and that is reasonably accurate.
Postings reflect my philosophies and perspectives on economics, business and politics.

Friday, September 11, 2009

One year on from the month of the most severe equity market collapse in twenty years, financial regulatory reform seems to have hit a brick wall.

I wrote quite a few posts concerning financial regulatory reform over the past year. This one, among them, stands out as being concise and pretty exhaustive in its prescriptions. Of course, that post doesn't deal with federal government-initiated problems such as Fannie Mae and Freddie Mac being directed by Congress to securitize too-thinly capitalized, unseasoned adjustable rate mortgages. But, rereading it a year later, I'm still okay with it as a useful set of regulatory solutions.

The recent action has moved from industry competitors to the regulators. With the new administration, much hot air has been spewed arguing for, or against, empowering the Fed to be the single, omnipotent regulator.

Isn't it odd that none of these financial sector regulations have managed to be enacted in the past year? About all we have is income caps on the CEOs of bailed-out banks. Those which have repaid the forced 'loans,' such as Goldman Sachs, are back to paying large bonuses again.But what of the development of exchanges for derivatives, so that a Bear Stearns of Lehman bankruptcy would no longer imperil long daisy chains of derivatives executions?What of the packaging of questionable debt into collateralized obligations?What of the GSE's pumping too-green, too-leveraged mortgage loans into their own securitizedissuances?How about the fact that the FDIC, Fed and OCC all missed what appear, in retrospect, to have been obvious inadequate mortgage loan documentation and/or improper lending to unqualified borrowers?None of this has been resolved.It's very curious and disturbing. Some of these regulatory steps would be very helpful in lowering the risk of a rerun of the mortgage lending bubble that did so much financial damage to the US financial sector and economy.Why has nothing been done in the past year?

Thursday, September 10, 2009

Back on August 21st, the Wall Street Journal published an excellent economic editorial by Alan Reynolds entitled, "Big Government, Big Recession."

As is the case with quite a few of our less partisan economists, Reynolds directly contradicts liberal apologist Paul Krugman. He begins by providing the impetus for his research and resulting editorial,

‘So it seems that we aren’t going to have a second Great Depression after all,” wrote New York Times columnist Paul Krugman last week. “What saved us? The answer, basically, is Big Government. . . . [W]e appear to have averted the worst: utter catastrophe no longer seems likely. And Big Government, run by people who understand its virtues, is the reason why.”

In rebuttal, Reynolds writes,"This is certainly a novel theory of the business cycle. To be taken seriously, however, any such explanation of recessions and recoveries must be tested against the facts. It is not enough to assert the U.S. economy would have experienced a "second Great Depression" were it not for the Obama stimulus plan.Proponents of Big Government can't say we avoided the next Great Depression due to hypothetical stimulus money that is mostly unspent. So they argue it's more important that the federal government merely continued spending and didn't "slash" spending as in the early 1930s. But the federal government didn't slash spending in the early '30s. Federal spending rose by 6.2% in 1930, 7.7% in 1931 and 30.2% in 1932. Since prices were falling, real increases in federal spending were huge during the Hoover years. President Obama clearly believes Big Government is the antidote to this and perhaps all recessions. At his first news conference in February, the president said, "The federal government is the only entity left with the resources to jolt our economy back to life." Yet that raises a key question: If the U.S. economy could not recover without a big "jolt" of deficit spending, then how did the economy recover from recessions in the distant past, when the federal government was very small?A 1999 study in The Journal of Economic Perspectives by Christina Romer (now head of the Council of Economic Advisers) found that "real macroeconomic indicators have not become dramatically more stable between the pre-World War I and post-World War II eras, and recessions have become only slightly less severe." Ms. Romer also noted that "recessions have not become noticeably shorter" in the era of Big Government. In fact, she found the average length of recessions from 1887 to 1929 was 10.3 months. If the current recession ended in August, then the average postwar recession lasted one month longer—11.3 months. The longest recession from 1887 to 1929 lasted 16 months. But there have been three recessions since 1973 that lasted at least that long."That's a pretty interesting nugget about Christine Romer, isn't it? Her own academic work concludes that the administration's so-called stimulus plan won't actually alleviate the current recession in any meaningful manner.But Reynolds goes further,"In the late 19th and early 20th centuries, nobody thought the government could or should do anything except stand aside and let the mistakes of business and banking be fixed by those who made them. There were no Keynesian plans to borrow and spend our way out of recessions. And bankers had no Federal Reserve to bail them out until 1913. Yet recessions after the Fed was created soon turned out to be much deeper than before (1920-21, 1929-33, 1937-38) and often more persistent. It's clear that U.S. history does not support the theory that Big Government means shorter and milder recessions. In reality, recessions always ended without government prodding, long before anyone heard of Keynes and long before the Fed existed. What's more, recessions ended more quickly before the New Deal's push for Big Government than they have in the past three decades. The economy's natural recuperative powers before the 1930s proved superior to recent tinkering by Big Government economists, politicians and central bankers."It's hard to argue with Reynolds, since he bases his conclusions on facts. But Reynolds, again, goes further, looking abroad,"The chart nearby lists 13 major economies by the size of government spending relative to GDP using OECD figures for 2007 (the U.S. is well above 40% by 2009). Europe's big spenders are at the top, the U.S. and Japan are in the middle, and fiscally frugal countries like China and India are at the bottom.The last column shows the change in real GDP over the most recent four quarters—ending in the second quarter for the U.S., U.K., Germany, Japan, France, Italy, Sweden and China, but the first for the rest. Four of the five deepest contractions happened in countries with the biggest governments—Sweden, Italy, Germany and the U.K. Japan's government spending in 2007 was about like ours, but Japan's tax rates are far more punitive and the economy has suffered endless "fiscal stimulus" packages. China's central government spent 22% of GDP, but 30%-plus with local government included.

To believe Big Government explains why this extremely long recession was not even longer, we need to find some connection between the size of government and the depth and duration of recessions. There is no such connection in U.S. history, or in recent cyclical experience of other countries."Again, it's difficult to refute Reynolds' rebuttal of Krugman's emotional contention that only Big Government has saved us this year.Reynolds then concludes his editorial,"On the contrary, recessions have become longer as the U.S. government (and the Fed) became larger, more expensive, and more involved in the economy. Foreign countries in which government spending accounts for about half of the economy have also suffered the deepest recessions lately, while economic recovery is well established in countries where government spending is a smaller share of GDP than in the U.S.

In short, bigger government appears to produce only bigger and longer recessions."Why do you suppose this is true? What is it about large-scale government intervention that causes recessions to be longer and deeper?I would guess it is two factors.The first is the distorting effect of government, which is to say, political meddling with price, demand and supply signals in an otherwise-free market for goods and services. Reading Amity Schlaes' excellent history of FDR's economic failure, "The Forgotten Man," brings home how destabilizing and distorting massive government economic intervention is. Investors hold back, worried about the shifting rules governing the context of their investments. Which industries will government punish or radically regulate next?The second is the nature of recession-based government legislation. Typically, it involves two things- printing or borrowing large amounts of money on the citizens' behalf, and creating or enriching transfer payment schemes.The first action leads to higher taxes, crowding-out of private investment, and higher interest rates down the road. None of which are necessarily healthy for the private sector, or a country, as a whole.The second action slowly, inexorably overlays a drag on economic activity, as new claims on behalf of non-producers are made and collected by big government. This saps savings in order to transfer wealth to those who consume without creating value in the economy. This additional marginal tax, in the form of items like FICA, predictably depress marginal economic activity across many income levels.These transfer payment schemes are rarely reduced or eliminated, so, over time, you probably have an accretion of this economic drag on productive private sector activity.Seeing as how our federal government, in just a few months of this year, actually doubled US indebtedness from the time of our country's founding to December of last year, it's hard to see how this biggest of all governments can possibly be consistent with an imminent and robust economy recovery in the US.

Wednesday, September 09, 2009

Back in late July, I wrote this post contrasting the economic punditry and outlooks of several well-known observers, i.e., Alan Blinder, Dick Hoey and Mortimer Zuckerman. My own conclusion was expressed as follows,"Who's right?Personally, I'd put my money on Zuckerman. Leaving aside that Dick Hoey was a fixed income manager back in the day, and his BONY/Mellon/Dreyfus bio doesn't exactly laud him as an economic Nobel Laureate, I don't think Hoey is sufficiently observant of the real differences in the effects of the recent recession on the US labor force from those of recessions prior to 1992."I continued with this observation,"That so-called 'jobless recovery' may well have marked a turning point for the US economy which has not yet been captured in various models and adequately observed by pundits-cum-economists like Hoey. Or even Alan Blinder.Prior to the 1991-92 recession and recovery, you are looking back to 1982-83, the early Reagan years, now very nearly thirty years ago. For perspective, was the 1960 economy different from that of 1930? Very much so. And the 1980 economy was so radically different from that of 1950, thanks to electronics and technological advances in communications as to make forecasting the former with models of the latter seem laughable.I suspect that's what is happening now. Those analysts and economists harking back to the early 1980s and using conventional models with estimates of consumer spending and labor growth have missed some important transformations in the US economy of 2009."These passages were what I was referring to in this post of last Friday, when I wrote,"I personally believe, as I've written in a prior post, that many economists are using inappropriate models and assumptions from over 25 years ago. Models and assumptions which are tied to a different type of economy and workforce than we now have. As such, I don't think they are correctly accounting for today's business IT allowing for previously-unimagined control of overheads and inventories.If economic recovery is based upon expectations of inventory rebuilds, I just think that's overly optimistic for the next few quarters."Apparently I thought about this topic a great deal more than wrote about it. Thus, this post.Though not an economist, as a trained marketing professional, I have been involved with quantitative behavioral modeling and analysis for decades. And, thanks to my business degrees, I've had more economics than most business students, in addition to which, I continually stay abreast of economic thought and opinion in the major business media.Currently, I believe that what macroeconomic modelling still exists, after the approach lost so much credibility in its early applications forty years ago, remains out of step with our modern US economy.For starters, the SIC codes were, and are, the underpinnings of most sector-based forecasting. These are now hopelessly outdated.Employment statistics are warped, thanks to the rise of subchapter-S and LLC entities. This has also served to obscure incomes, as business income for many entrepreneurs now appears on 1040s, rather than corporate returns.Finally, the entire nature of business operations, being now so heavily dependent upon, and benefiting from computer-based management tools, has changed from 30 years ago.As an observer who understands economics and business, I find myself wondering just how we can accept economists' references to the jobless recovery from the 1991-92 recession, without explanations as to how this phenomenon has been incorporated into current models.It's important to know whether economists consider the 1991-92 recession an aberration, or a new paradigm.A reader commented on my post of last Friday, taking a shorter term, more narrow view of individual recent IT spending by companies. What I meant by my comments in that post was that business has been improving operational information availability for nearly 30 years, with the arrival of the personal computer in 1980. When I was with Andersen Consulting in the mid-1990s, client/server projects were booming, and a sort of internal internet, LotusNotes, was being applied at individual firms.It's safe to say that business communications and information movement has changed more dramatically and functionally from 1980-2010 than from 1930-1960, or from 1960-1990.Specifically, the recent period has smoothed supply chain management between companies, so that the holy grail of goods-producing companies, inventory management that is as synchronous with retail sales as possible, has come a lot closer to reality.Now add to this the rise of outsourcing, both onshore and offshore, and you have corporate employment becoming less sensitive to production volumes. Employment at suppliers becomes more volatile, but those jobs tend to be lower-compensated than the ones they replaced at the larger corporations.Now add to this mix the public consuming business and markets information via free cable networks, such as CNBC or CNN. Today's consumer can view the reaction of institutional investment managers to some obscure report, previously unknown to consumers, such as durable goods orders, or employment reports, in real time.Thus, consumer spending and confidence are able to be affected nearly immediately by financial market reactions, which affect the wealth of consumers via asset prices in their various investment accounts.We probably have a tighter-, faster-linked series of economic phenomena which affect each other as inputs and outputs of information, goods and money flow, than ever before. Certainly far more than thirty years ago.Is it any wonder that you see employment levels less responsive to economic recoveries in recent decades? Or spending and saving rates affected by generally-available unemployment information?It is simply stunning to me to read yesterday's Wall Street Journal piece wherein a number of financial pundits were opining on how fast and robust the deep "V-shaped" recovery is going to be.How do they account for the lack of re-employment of so many recently-unemployed? The defaulting and delinquent home loans? The coming commercial mortgage loan delinquencies and defaults?Yes, any, or even several of these, in moderation, can be accommodated by a vibrant, recovering economy. But this last recession was, is, different. The scale and breadth of its effects have left conventional financing sources weak and unable to profitably lend at current rates.There is so much about this recent economic recession, in concert with a financial collapse, that is different from anything the US has experienced in the past 30 years that it's simply difficult for me to trust pundits who rely on conventional econometric models to forecast that the 'usual' recovery has begun, and will surprise us all.

Tuesday, September 08, 2009

A little over a year ago, amidst the then-year-old unraveling of mortgage-backed securities which decimated the US banking industry, I wrote this post concerning Terry McGraw's push for growth at his Standard & Poors, McGraw-Hill's rating agency unit.

Now a case is moving through US courts that could spell the beginning of the payback by S&P and McGraw-Hill for its cavalier approach to ratings over the past few years. The Wall Street Journal covered it last week, and I noted to myself, upon reading the article, that it could spell disaster for the firm.

This morning, CNBC had McGraw-Hill CEO Terry McGraw on to defend the company's position. And Terry didn't disappoint. He claimed that the judge had tossed several charges on first amendment bases, and that only one remained, so the company was in great shape.

Ah, not so fast, Terry.

In a move calculated to boost ratings, which is understandable, the program then aired a telephone interview with occasional guest host and periodic guest, Greenlight Capital hedge fund manager David Einhorn.

Einhorn, though far from perfect, is noted for having correctly shorted Lehman last year, publicly dueling with its CFO and questioning the now-defunct firm's valuation of various real estate assets on its balance sheet.

Einhorn confirmed on the air this morning that his fund has shorted McGraw Hill's stock. He went on to give a very detailed explanation of how, in his opinion, Terry McGraw's prior defense was incorrect and overly-optimistic.

Basically, the case boils down to this. Publicly-available ratings by agencies are deemed 'protected speech' under the first amendment. You can't sue S&P for their public rating of a bond or CMO issue. Even if it was obviously, in retrospect, flawed and poorly-determined.

However, the case in question involves S&P providing ratings opinions on securities to a non-public investing group. This, the court found, is not protected speech. Thus, possible charges could involve fraud.

Einhorn stressed that S&P has never, in the past, had to worry about being sued for its opinion. The fact that this is now about to happen is a watershed event for it, and its competitors, Moody's and Fitch. He opined that other suits will likely now follow, especially if S&P loses this case.

Then there is the question of damages. Einhorn noted that none of the ratings agencies, similar to what occurred with MBIA's under-reserved financial situation, have the financial depth to actually pay damages on fraudulently-rated securities.

As the 5-year price chart for MHP and the S&P500 Index reveals, Terry McGraw's company has struggled for most of the past five years simply to remain comparable to the index. For the past two years, since late 2007, when the ratings mess began to become public, it's basically been underperforming the index.

It's a decent bet that any serious legal problems at S&P are going to really put pressure on the firm's performance, and maybe, in time, Terry's job. After all, per my post of last August, he was running S&P on a pretty thin funding stream while pushing for massively greater profits and volumes from the unit.

It looks like that strategy is now coming home to roost at the firm, in the form of the investor lawsuit based on the private securitized bonds ratings.

About Me

A well-educated veteran of US corporate strategy positions & hedge fund management, as well as research, product development and project work in consulting, strategy and equity management. Academic background in marketing, strategy, statistics and economics.
Currently own Performance Research Associates, LLC, through which I am involved in proprietary equity and equity options investment management.